Weakness in the housing and job markets remain the biggest economic challenges but modest growth should cause unemployment to edge lower over the next year, Federal Reserve Chairman Ben Bernanke said Wednesday.

The Fed chief also supported financial regulatory overhaul -- while defending the central bank's turf -- and warned the nation's unsustainable deficits threaten future financial stability and growth.

Despite no evidence of a sustained recovery in the housing market and soaring levels of long-term unemployment, Bernanke expects economic conditions to improve, leading to increased consumer spending and easier credit.

"My best guess is that economic growth, supported by the Federal Reserve's stimulative monetary policy, will be sufficient to slowly reduce the unemployment rate over the coming year," Bernanke said in a speech at the Dallas Regional Chamber of Commerce.

The Right Kind of Reform

Bernanke supported financial regulatory reform and the end of "too-big-to-fail" institutions, but also defended the Fed's current oversight role of smaller banks, something proposed legislation would take away.

"We need tough new rules to make financial institutions safer and to constrain excessive risk-taking, and we need a regulatory framework that gives the Federal Reserve and other agencies the ability to address risks to the financial system as a whole," Bernanke said. The Fed chief added that the central bank has already reformed its own regulatory and consumer protection efforts.

Taking the longer view, Bernanke said the country's growing debt burden and aging population threaten future prosperity. "To avoid large and unsustainable budget deficits, the nation will ultimately have to choose among higher taxes, modifications to entitlement programs such as Social Security and Medicare... or some combination of the above," Bernanke said.

"Unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth," the Fed chief added.

Bernanke said that in the near term, "inflation appears to remain well controlled." On Tuesday the minutes of Fed's last policy meeting confirmed the central bank's commitment to a near-zero interest rate policy for an indeterminate period of time.